Feature

Guesses for the New Year

by Jim Forbes

If I could make one prediction for 2003, I would forecast
that you would not see many predictions about rental
housing for 2003. At least there won’t be any
that contain a sense of certainty or clarity, or that
sound positive. We head into a new year with less going
for us than in 2002, and this includes the lack of any
consistent indicators. How this will affect rents and
real estate prices is anyone’s guess. San Francisco
rents may soften a bit more, but probably no more than
5 to 10 percent or so off 2002 levels. Returns on purchases
will continue to be at historic lows. Okay, these are
only my guesses. But there are several reasons why I
think the direction the market will take in 2003 will
not be much different from what we saw in 2002.

Rental Market
San Francisco rents are in the midst of the worst downturn
in the past 35 years, perhaps since the Depression.
From the peak of October 2000, rents have dropped 40
percent. For 2002, the median-priced two-bedroom rent
added 6 percent toward that total and is down 13 percent
from last January. We have now returned to a level not
seen since the summer of 1998, when rents had dropped
from $2,000 to $1,850 in a brief reprieve after the
torrent of increases in 1997.

With this latest drop, rents have now started to fall
in line with the CPI (Consumer Price Index), or at least
in terms of their historic relationship to it. Since
1967, the first year for which I have data, annual increases
for San Francisco rental rates have averaged 159 percent
of the CPI per year. From 1967 to 1995, rents were a
total of 152 percent of the CPI, with the peak in 1986
at 169 percent. Beginning with the blistering increases
of 1996, rents skyrocketed from 188 percent in 1996
to over 300 percent in 2000. Clearly these figures for
four years were out of sync with historic ones. They
are now at 198 percent.

To get back in line with the 1995 figures, rents would
have to plummet another 20 percent. I don’t see
this happening. Thanks to the largest increase in personal
income ever recorded (a function of better jobs and
replacement of lower income families with higher income
ones), the 1996 level of 188 percent is probably the
new bottom. This would mean a 5 percent drop from where
we are today.

In addition, with the recent 13 percent price drop,
San Francisco rents are now in-line with other major
metropolitan areas in the state. With 1996 denoting
the ground zero point for the four-year boom market,
according to statistics maintained by the national real
estate apartment firm of Hendricks & Partners, San
Francisco rents combined with Marin County’s have
climbed 46 percent. Meanwhile rents have also grown
48 percent in West L.A., 45 percent in San Jose and
47 percent in San Diego. (See graph for how we got here.)

Although I am partial to our economy over that of Southern
California, theirs is more diverse and thus should be
more resilient to our present high-tech slump. Further,
I would not be surprised to see rents in Southern California
decline somewhat. This might be especially true in L.A.
with “for rent” signs everywhere. The average
increase in this area has been in excess of 7 percent,
which is an aberration there.

There are other reasons why I think rents will be down
a bit in 2003. The first reason is that we have some
horrendous government budget shortfalls that when bridged
will remove billions of dollars from the economy, completely
negating any benefit federal tax cuts may have. In San
Francisco, our budget problems are acute because the
city and county numbers play havoc with our local economy,
especially when added to the state’s $34.8 billion
shortfall. Government spending, although many of us
don’t like it, provides funding that goes into
the hands of tenants and prospective tenants, which
in turn creates demand for our product.

The second factor is that supply is on the rise. The
large-scale building of residential units South of Market,
though not as much as in the early 1990s, provides prospects
with more options to buy or rent. The consequence is
that tenants have greater leverage in negotiating a
lower price with potential landlords. I have even read
that a large commercial developer in San Jose is ripping
down office buildings in order to build residential
units on the same site. As San Jose competes with San
Francisco both in terms of jobs and housing, even this
kind of addition to the supply side of the equation
can cause rents to soften.

The third issue is the fluidity of the job market.
Although normally I would list this first in terms of
its impact on rental demand, I think much of the job
loss in San Francisco has already occurred. Most, if
not all, of the future lay-offs should occur outside
of the city limits. Throughout the Bay Area—in
spite of the impact that the market’s fluidity
and related layoffs have on overall rental demand—prices
and opportunities have probably reached a point where
job increases will occur here in town. This is due in
large part to companies that may want to relocate at
1998 prices, at least in terms of their own costs for
office space and rental rates for their employees. The
only factor that could keep the brakes on the relocation
of companies back to the city is home prices, which
remain astronomical.

A fourth factor is the price of homes. Even though
rents have come full circle to July 1998 levels, median
home prices have nearly doubled since then. They have
increased 72 percent with prices now at $550,000, which
creates a significant barrier to renters who wish to
permanently exit the rental world. If home prices had
also plummeted 40 percent, I would conclude that rents
could very well drop another 20 percent, in part because
prospective renters would quickly be on the purchase
circuit. However, this scenario is far from happening.
(For those of you who like statistics, the increase
of San Francisco home prices has averaged 255 percent
of the CPI since 1982; currently prices stand at 325
percent.)

Sales Market
Compared to home prices, apartment buildings and in
fact other income producing real estate are also selling
at unprecedented highs vis-à-vis rents. This
is partially because there is just too much money out
there chasing too few good deals. Maybe the Bush Administration’s
proposal to eliminate the taxation of dividends from
stocks will do something to suck away some of this cash
that is bidding apartment building prices to near below
five percent returns. All I can say is if interest rates
ever go back to 8 percent (let alone 10 or 12 percent),
the housing question could get real ugly.

Meanwhile, buyers continue to evaluate deals based
on recent closings, which further perpetuates the insanity.
In addition, Sec. 1031-trade buyers who earlier got
out high are now resigning themselves to pricier purchases,
often made under duress of a high tax bill. Agents working
the buy side often won’t even talk to a buyer
until the buyer is in the 45-day identification period,
because agents know the buyer will need that kind of
motivation to actually compete. Meanwhile, the agencies
that control the listings such as Marcus & Millichap
are having their best years ever.